Fed Officials Offer Hope on FOMC Interest Rate Action

July 13 – “Why hasn’t the FOMC yet raised rates?” Esther George, president and CEO of the Federal Reserve Bank of Kansas City, would like to tell you. In a recent speech at the Oklahoma Economic Forum in Stillwater, George noted that during her first voting rotation on the Federal Open Market Committee in 2013, she did not support a third round of asset purchases. “By then,” she said, the immediate crisis had passed, the economy was slowly expanding for its third consecutive year and monetary policy settings remained extraordinarily accommodative.

“At the end of my voting cycle, I fully anticipated that a return to more-normal interest rates would require a lengthy and gradual adjustment process,” she continued. “But I did not imagine that in 2015 we might still have the same policy stance.”

The FOMC has been talking about its exit strategy since 2011, George pointed out. And since March of this year, it has been emphasizing that a decision to raise interest rates would be data dependent. In other words, economic data that confirms further gains in the economy’s performance will drive the timing of the committee’s actions.

There are, of course, different views on the economic data the FOMC receives and analyzes that lead to legitimate, differing views about what is best for the economy, she pointed out. The Federal Reserve is charged with committed to objectives that take into account employment and inflation in order to foster stable long-term growth in the economy. But policymakers may differ on the appropriate path to achieve these long-run goals, George conceded.

Of course, the economic data the committee relies on can, and often does in the short run, send conflicting signals. “As a result, policymakers are faced with an unclear path for moving interest rates,” George said. “Those choices are all the more difficult as we must rely on backward-looking data to frame a forecast that takes into account the long lags of interest rate changes.”

Under such circumstances, the Federal Reserve must be especially careful to avoid reacting to the last data point to determine policy, according to George. “The real challenge when the data disappoints is discerning whether it is due to temporary factors or an early signal that underlying momentum in the economy is changing, she said.

For example, the current estimate is that the economy contracted in the first quarter after three quarters of relatively strong growth, George noted. While this “headline number” raises caution for policymakers, other factors suggest the slowing is likely to be temporary, she believes. Severe winter weather and labor negotiations concerning dock workers likely took a short-lived toll on growth. At the same time, however, the economy added nearly 600,000 new jobs in the first three months of this year.

“So even though the economy appeared to slow a bit in the first quarter, businesses kept hiring, and the data for the second quarter suggest the economy is again expanding,” George said.”Thus, in the face of consistent positive trends, delaying actions for more positive data can be unwise.

As for inflation, the data suggest to George that it is understood why inflation has been low, and as some temporary factors fade, it will likely move back toward the Fed’s goal.

“The continued improvement in the labor market, combined with low and stable inflation, convince me that modestly higher short-term interest rates are appropriate,” George said. “Current guideposts, or ‘policy rules,’ often used to inform monetary policy decisions also have been signaling that interest rates should be higher.

“I recognize that a rate increase, however, would be the first one in nearly a decade,”’ she added. “So I am not suggesting rates should be normalized quickly or that policy should be tight. Although the economy has improved, economic fundamentals could well mean an accommodative stance of policy is appropriate for some time. I would like to avoid the cost of waiting for more evidence and further postponing liftoff, drawing on a valuable lesson from monetary policy decisions in 2003.”

At that time, the federal funds rate was held at a very low level—1 percent. Inflation excluding food and energy in late 2003 was running at about 1.3 percent, not dissimilar from today. The unemployment rate was slightly below 6 percent, again, not dissimilar from today.

“By the middle of 2004, core inflation increased to 2 percent as the unemployment rate continued to decline,” George said. “A gradual tightening cycle began in June 2004. Core inflation then moved persistently above 2 percent, and the labor market began to overheat amid one of the most historic credit bubbles in U.S. history.

“Of course,” George concluded, “many would argue that we do not face a similar buildup of leverage today and that the recovery remains fragile. Perhaps so, and perhaps this time it’s different. However, economic trends and experience suggest otherwise.”

The day after George spoke in Oklahoma, Federal Reserve Chair Janet L. Yellen cautiously raised expectations for a rate increase this year in a speech at the City Club of Cleveland, Ohio.

“I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy,” Yellen said. “But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step.”